Tax Planning Triumphs: Converting Tax Savings into a $2 Million Boost for Your Painting Business

Welcome to the Profitable Painter Podcast. The mission of this podcast is simple: to help you navigate the financial and tax aspects of starting, running, and scaling a professional painting business. From the brushes and ladders to the spreadsheets and balance sheets, we've got you covered. But before we dive in, a quick word of caution. While we strive to provide accurate and up-to-date financial and tax information, nothing you hear on this podcast should be considered as financial advice specifically for you or your business. We're here to share general knowledge and experiences, not to replace the tailored advice you get from a professional financial advisor or tax consultant. We strongly recommend you seeking individualized advice before making any significant financial decision.

This is Daniel, the founder of Bookkeeping for Painters, and this is Richard, tax director with Bookkeeping for Painters. So, Daniel, I've got kind of a little fun thing for us to do today. You know, a lot of folks are asking how valuable is tax planning? And sometimes it's kind of hard to express that. So I thought maybe it'd be fun to kind of go through a hypothetical scenario, you know, put some numbers down on paper and kind of show folks just how powerful tax planning can be.

Sounds good. I like it.

Yeah, yeah, yeah. It's, it's, it's going to be fun. As fun as taxes can be, right? That's what we do here. We make taxes fun, or at least slightly less painful through, through bad jokes. So I'm, I'm calling this The Power of Tax Planning: A $2 Million Strategy. And so the idea behind this is, can we take what we're already spending So no new spending, just what we're already doing. And can we turn that into $2 million over the course of our career? And I think, I think folks are going to get a kick out of this or at least be a little bit more aware of just how powerful these strategies can be.

Yeah, $2 million, that's a pretty good chunk of money.

Yeah, it's ambitious. So hold me to it, okay? Don't let me get off without showing you the— showing them— what was that, Jerry Maguire? Show me the money, right? We're going to show you the money. So $2 million tax strategy. And, you know, I would love it if there was just like a secret sauce, like that one weird trick the IRS doesn't want you to know that gets you $200 million or $2 million. That's not the case. In reality, $2 million is earned through a lot of smaller, wise decisions over a period of time. But the money is there. So the first thing we got to do is we got to know our numbers, right? We're not going to leave this to chance. This isn't something that's going to fall into our laps. We have to be very intentional about what we're doing. And one of the first things we're going to want to do is understand and set realistic benchmarks for our business. That includes understanding how our profit margins are going to change as our business matures. We think about like a typical independent painter, maybe he has a crew of 3 to 4, and he could probably expect gross revenue of around $500,000. This is an average number, so, you know, your mileage may vary, but this is the amounts that some of the more popular painting franchises believe that their franchisees can earn. And if you have a crew of about 3 to 4 and you're earning gross revenue of $500,000, then you're probably looking at a profit margin of anywhere from 16 to 24%. So $80,000 to $120,000.

And so that's basically a painting business owner that's doing the sales and production management, and then they have a few, 3 or 4 crews below them that's helping them execute the work.

Exactly. Yep. So this is earlier stages of your business. You know, a smaller crew. Now, as time goes on, typically, you know, 3 to 5 years depending on, you know, different things, you're going to see a more mature business and you're going to see that painting business owner transition away from being on the brush to more of a management-only role. At this point, you know, your gross revenue is going to be closer to $1 million or more. And your profit margin is actually going to shrink a little bit as your business grows to 15%. But, you know, 15% of a watermelon is better than 20% of a grape. So your net profit is going to go up. The actual profit you get is going to go up to closer to around $150,000 a year.

Okay. So this would be basically You have your crews and then you've hired a salesperson and a production manager. And so now you're just making sure everything's working basically.

Exactly. Exactly. You've transitioned into the CEO of your painting business. And as we mentioned, this is typically after about 3 to 5 years or sometimes longer depending on the market. Of, of operating. So now you're bringing in $150,000 of taxable income every year and you really want to consider how you're going to pay your taxes on that and how your business is going to be structured. And this is where having the right business entity is really key. This is a big part of the tax planning we do making sure that you have the right business entity for the right phase of your business. When you first start out, you're almost always going to be what they call a sole proprietorship. So a one-man owner. Now, you may have an LLC as your legal entity, and that is still taxed as a sole proprietorship. This is a very simple business structure where the business and the owner are one and the same, at least for tax purposes. You're going to file your business taxes on your personal Form 1040. You're going to use Schedule C, and that's where you're going to put all of your, your profits and pay your taxes. In this type of taxation, you have to pay what they call self-employment tax. If you're not familiar with that, that is the self-employment version of Social Security and Medicare taxes, also known as FICA. So just like when you work for somebody else, you have to pay that Social Security and Medicare tax so that we can continue to fund these programs. You get to pay that as self-employment tax when you're self-employed. So that is assessed on all of your earnings, all the way up to $168,600. That's the Social Security limit for 2024. That will go up as inflation goes up. And then you have the privilege of paying the Medicare tax indefinitely. So there is no cap on that.

So, so basically, as a sole proprietor, I mean, because you hear a lot about double taxation for C corporations, but kind of as a sole proprietor, kind of getting double taxed here as well because you're having to pay the self-employment tax. And then on top of that, you have to pay your tax bracket tax, whatever that is as well.

Yeah, that's a good way of putting it. You're paying taxes as a, you know, as someone who's entitled to the profits of the company. But you're also paying taxes as the employee of the company. So yeah, it is, it is a very, you know, kind of heavy, heavier tax burden. But that structure is appropriate for people just starting out because it is simple. It has the least startup costs, the least accounting costs. And, you know, it's kind of where we all start. But as the business grows, you might want to talk about moving into a more tax-favored structure where, like you were saying, Daniel, you can avoid some of that self-employment tax. So that's going to be your S corporation taxation. S corporation allows you to kind of separate yourself into two camps. You've got the employee who works for the company and collects that paycheck. And pays those payroll taxes. And then you have the investor who collects profits from the company but does not pay payroll taxes on his profit distributions. The way it works is that you have to pay the employee part of you a reasonable amount for the work performed. And that right there can be a tax planning challenge in and of itself. You know, what is a reasonable amount? Because the IRS does not give us an answer. They tell us that you have to determine what reasonable compensation is, and if they don't like it, then they're going to audit you. So it's— it can definitely be tricky and you definitely want to have good calculations to back up your number because you don't want to go too high and pay more taxes than you need to. You don't want to be too low either and start raising red flags at the IRS. So we like to dial that in real specific and have, you know, really good data to back up our position in case we ever do get audited.

And basically that means like identifying what roles you do in the business, right? And then what would you pay someone else to do those roles, and that would be basically your reasonable amount. So you can kind of do some Google searches if you're left up to your own devices, maybe some Google searches on your area, like Glassdoor, I think is one of them, will show you like salary rates for a salesperson in your area or a production manager in your area, some salaries. And so kind of piecing those together, you could, because you're probably doing more than one role in your business. So kind of piecing those together because you're probably part-time in a lot of those roles. And then, you know, so you may be doing, you're like 20% of the time you're doing sales and then 20% of the time you're doing production management, 20% of the time you're doing admin work, you know, so kind of piecing those together to come up with a reasonable salary. Based off of what you would pay someone else to do it. Is that kind of the idea there?

Yeah, that's exactly the idea. Your reasonable compensation is— there's a lot of criteria, but to kind of put it in a nutshell, like you said, Daniel, what would you have to pay somebody else to do the work that you're doing? And you do wear a lot of hats as a business owner. So when you are on the brush and you are doing high-quality craftsman work, you would have to pay yourself more money than when you are filing paperwork in your office. So we want to separate those things. I don't want to pay $50 an hour for, you know, $20 an hour work. And then it depends on where you live too, because people who live in, you know, Southern California get paid more than people who live in rural Texas. So we, we dial it down really well. Um, we use data from like the Department of Labor and the Census Bureau. It's down to the county that you live in and all the different tasks that you do. So we get your reasonable salary down as low as we can. And that right there is a big tax, uh, planning issue because, you know, every $1,000 you pay yourself in salary is $150 in payroll tax. So we get that down as low as possible. But if you are doing this yourself, certainly Glassdoor, Monster, Indeed.com, look to see what other people are paying for the jobs you do in your area, and then it will give you a good idea of what your reasonable compensation should be. So once you pay yourself your salary, we get that out of the way, then the remaining business profits are available to you as the investor. And when you take these profit distributions, you do pay your normal income tax on them, but you don't pay any payroll tax. So that 15.3% goes out the window and you can take those payroll tax-free. So let's just kind of throw some numbers at it. I know I promised that at the beginning. Let's do sole proprietorship. Versus S corp. So you've got your painting business, you've been in business for 3 to 5 years, you're hitting your $1 million profit gross— not probably $1 million in gross revenue with a net profit of 15%. So you're getting $150,000 a year profit. If you are a sole proprietor, you're going to pay 15.3% self-employment tax on the entire $150,000. That is $22,950 of just self-employment tax. Doesn't include income tax, state tax, anything like that. If that exact same business was to elect S corp and let's say reasonable compensation in this case was $50,000 a year, maybe more, maybe less. But for this purpose, we'll say $50,000. Well, the payroll tax on that $50,000 is $7,650, and the payroll tax on the $100,000 that's left over is zero. So in this case, an S corp would save $15,300 every year over a sole proprietor of the exact same business circumstances.

It's, it's like as much as some people make in a year.

Yeah. Yeah. When you think about what could you do with an extra $15,000 a year, you know, maybe reinvest it in your business. I'm going to offer an alternative that also has to do with tax planning. And that has to do with tax-advantaged retirement accounts. Now, I think some of our listeners are— I might start to lose some of you when I talk about retirement accounts because sometimes we think I'm too young to worry about this, or I don't trust the stock market, or I'm just not interested in putting my extra $15,000 into something that I can't touch until I'm 59 and a half years old. I totally get that. There are options available that might help alleviate some of these objections. And so I'd like to talk about, you know, some of the different ways you can use this tax-advantaged retirement account that might be more favorable to you. You know, traditionally you've got your good old IRAs and traditional 401(k)s. You know, we're familiar with that. The money goes in, you pay no taxes on it. You invest in stocks, mutual funds, bonds, Fidelity or E-Trade or Merrill Lynch. They take care of your money and you pull it out when you retire. That's definitely one way that you could do it. Another way has to do with self-directed 401(k)s, and that is where you have control over your money to choose different types of investments that Fidelity doesn't offer. You can buy stocks and bonds. You can also buy real estate, residential real estate, commercial real estate. You can form LLCs and create new businesses inside your retirement account. So we know you're— you know how to build a business. You've already done it once. Maybe you want to do it again and this time not pay any taxes on the money until you go to retire. You can invest in other businesses if it's set up correctly. You can basically have checkbook control over your retirement account. And as long as all the profits stay inside that retirement account, and you don't pull them until you go to retire, you won't pay any taxes on those profits.

That's pretty crazy to not pay. Like, you can basically have another business that you would set up and not pay any tax on that business. That's, that's kind of crazy. Or real estate or, you know, whatever it is, uh, putting your money to, to work in a, in a way, in, in some sort of vehicle that you know about. Because some people are, like you had mentioned, are hesitant to put their money into the stock market or into things like into other publicly traded businesses when they don't know about it. And, and so that might have less of a good feeling to, to do that, where when you could do self-directed you can put it into something you really know a lot about, like maybe it's real estate or maybe it's, you know, a certain type of business and you can have more control over that and then also get a huge tax advantage. So that's a pretty cool thing. I don't think a lot of people know about that.

Yeah, absolutely. So these qualified retirement plans that, that get us these tax breaks, that's the vehicle. What we put in that vehicle is up to us. It could be stocks, bonds, real estate, other businesses, gold, cryptocurrency, all sorts of things that can grow our money that, like you mentioned, Daniel, we're comfortable with, we have knowledge about, we can have that control. But it does require a little bit of paperwork and setting things up. In a right way, you're working with a tax planner and perhaps a lawyer to, to build these self-directed IRAs so that you can have that extra level of control. You're not going to get that from, you know, your typical Fidelity or E-Trade, but it's definitely doable. All right. So in our example, we're taking our $15,000 or $15,300. Don't don't forget the $300, and we're contributing that tax-deferred. If we are a married filing jointly taxpayer who's making $150,000 a year, that puts us in a 22% tax bracket. So our $15,300 contribution reduces our taxes an additional $3,366 a year. So that's what the government is going to pay us to put our money into retirement. No, what do you—

I'm sorry. So basically we saved $15,300 by taking a reasonable officer salary and S corp and taking that $15,300, putting it into a retirement plan that allows us to deduct the cost to deduct what we put in on our taxes, what we put into the retirement. So otherwise called tax deferred, meaning we don't have to pay taxes on the money we, we contributed into retirement. And so that, that's where that extra $3,366 comes from in tax savings, right?

Yep, that's exactly right. I appreciate you clarifying that. The $15,300 that is a savings on payroll taxes. The $3,366 that we get from contributing our savings to our retirement account, that is a savings on income tax. So we're getting it from, from two different sides here. You know, we're pushing, what, $18,666, I think, in total. And that's each year. That's not just one time. It's each year that we make $150,000 in profit. And, and by the way, if, if you make more than $150,000 in profit, which is certainly doable, then your savings is just going to be that much higher. So what would you do with $3,366 each year? Uh, at this point, I kind of like to suggest maybe think about spending it on yourself, kind of reward yourself for your, your good planning here. Uh, that money could be used for, say, like a yearly vacation, uh, maybe holiday gifts for the family. That would be a, a pretty Merry Christmas. Maybe there is a charitable organization that you feel passionately about and you would like to promote and help them with their cause. Uh, If you don't want to spend it on yourself, you can always reinvest it back into your business. Maybe you could do quite a bit with that, that $3,300 a year in, you know, new equipment, new marketing. If you have children, think about a college savings plan, a 529 plan. The money goes in, it grows in the plan. and then when you take it out for college, it comes out tax-free. So that's kind of the opposite of our traditional IRA. That's more like a Roth IRA. Or you could take that $3,366 and add it to the $15,300, put the whole thing into your retirement savings and really grow that retirement account. So you have different options. Uh, it is up to you what you'd like to do. So as we're doing this year over year, our money is slowly growing— maybe not so slowly, maybe more quickly growing— but quietly in our retirement account. Let's put some numbers down to see just like how much we could actually grow this, this retirement account? I got two different, different scenarios here. The one I like to call set it and forget it. I'm very good at— I'm much better if you can set me up with a routine, something that I don't have to think about. So if you want to kind of set it and forget it, you could invest in the US stock market, maybe mutual funds or index funds. This is something that you can do through your typical, you know, Fidelity 401(k) or IRA. You don't need to try and do anything self-directed for this. And if you just bought, you know, shares of the S&P 500, which is, you know, the 500 largest U.S. companies, and you put your money in the U.S. economy, you would see an average return on investment of about 9.9% year over year. At least that's what it's been over the last 30 years. The US stock market, adjusted for inflation, typically returns just under 10%. We put our $15,300 a year in there for 30 years at 9.9% annual growth. We would end up with $2,000,000 $469,595 after 30 years. So that's—

so that's— that's after putting all the tax savings from the S corp change just into that retirement and getting that return from the stock market, just doing that every year for 30 years. Yep.

Yep. You take the money that you were paying to Uncle Sam in payroll tax or self-employment tax and you pay it to your retirement account. You just buy index funds, nothing fancy. You don't have to think about it. You don't have to go and get a broker. It's low cost. 30 years. If the stock market does what it did in the last 30 years, in the next 30 years, you're looking at just under $2.5 million.

Yeah, and $2.5 million. If there's this rule in finance, personal finance, 4% rule. I don't know if you've heard about it, but basically, yeah, 4% is if you have a nest egg of money in, uh, put into a something that's giving you some sort of return. Let's, let's say you keep it in, in the stock market, you know, um, and let's say you're 30 years old when you start doing this, right? And so you said you do this for 30 years, so you're 60. And you have $2.5 million in, in your index funds, and maybe you want to, you know, sell your business and kind of take it more easy, do traveling, whatever you want to do, and you have $2.5 million in your index funds. The 4% rule says that if you just keep it in there and you only withdraw 4% per year from that $2.5 million, that with a high probability of like 98 or 99%, I don't know, I don't remember the details, but with a 98 or 99% probability, you will not ever withdraw enough to completely deplete the, um, the $2.5 million. So basically, you will leave that $2.5 million for your, for, you know, your children or whoever after you die. So, so you— and then 4% of $2.5 million is like $100,000. So you could basically live off of $100,000 in perpetuity forever. You know, maybe they solve aging and you could just, you know, live off of $100,000 forever. And that's, that's a I mean, that's, that's a pretty good deal. I mean, I could live off $100,000 a year.

Yeah. And my favorite part of that 4% rule is that it's inflation adjusted. So we say $2.5 million. We're talking about today's money. You hold on to this nest egg for 50 years and you pass it on to your children. They're not getting $2.5 million in 50 years from now money. They're getting whatever it is inflation adjusted. So that they have the exact same earning power that you did when you built this nest egg. So yeah, definitely.

So basically to say it like, how many Teslas can you get with $100,000? Was it 2 Teslas?

Sure. Well, we'll go with 2 Teslas.

So basically you could buy 2 Teslas per year with your money. Forever, even when Tesla raises their prices of, you know, each year.

So, right, but then don't forget you have to charge them. So, no, we'll have a little leftover to build the 100 electrical outlets that we're going to need. Yeah, so, you know, I love this set it and forget it, especially for younger business owners who are in their 20s who have an obvious 30 years ahead of them. But what if you're more like me? You're getting— well, okay, I'll admit I'm middle-aged. I don't have a full 30 years ahead of me to do this. I need to get— I need to get a better rate of return. I need to kind of, you know, kick it up a notch. So my second scenario has to do— I call it the high achiever. We're all Type A personalities trying to get as much as we can. So we're going to take that, you know, that extra money that we got from the tax savings and we're going to add that to our $15,300. We're going to put all of that into our retirement. So now we're at $18,666. We'll buy our own Christmas gifts, we'll pay for our own vacation. This is all going into our retirement. And we can't settle for 9.9% annual growth because we don't have that much time. So this is where our self-directed IRAs come in. This is where we are investing in real estate, other businesses, more profitable investments. Yeah, there's more work involved, there's more risk involved, but we want a higher rate of return. So if we were able to do that and get a 16% annual growth, so that would be kind of like opening another business and getting 16% profit margin or 16%, uh, rate of return on a piece of rental real estate, and we only had 20 years, we didn't have 30 years, well, we would be able to finish our, uh, our nest egg at $2 million $154,370. So not quite the $2.4 million of the other scenario, but we also only work at this for 20 years instead of 30.

Yeah, that's pretty— still pretty good. I mean, with $2.1 million in the bank, you know, the 4% rule says you could take about $80,000 out per year for us forever and not touch the principal. So that's still pretty good.

I'm not going to complain about $2.1 million in the bank. Yeah. You know, and, and this is just your retirement. Think of how much money you're going to get when you sell your business or if you have other sources of income. I like I liked using this example because a lot of us don't have the 30 years. We've only got 20, maybe even less, and I wanted to show that it's still obtainable. It may require a little bit more effort, but we can still hit that $2,000,000 mark. Now, what if we did have 30 years and we were aggressive and we really went for it and we got that 16% annual growth rate? Growth on $18,666 a year for the full 30 years. What could we do with that? Well, that number comes out to be— and you're probably not going to believe me, so I encourage you to go ahead and do the compound interest calculator for yourself— it's going to be $9,901,980, just shy of $10 million. Daniel, what would the 4% rule say about $10 million for a nest egg?

It's like $400,000 a year. Not too bad.

Yeah, I could do that.

Yeah, that's, that's a lot. $400,000 bucks a year. It's hard to— hard to— you'd have to figure out ways to spend that.

Well, if you need help spending it, I will give you my Venmo. And, and I will even pay the taxes. Like, it's cool. Like, I will help you out like that. Yeah, I'm a nice guy. But so it's kind of fun to throw these numbers around. This really illustrates the power of compound interest. When we're young, we have a window to start doing this. That window closes as we get older. This is not something that is as easily attained as we get into our 40s or our 50s. So my big encouragement is if you're in your 20s or even your early 30s and you haven't thought about retirement planning because you're young and that's a long way off, think about retirement planning, even if it's just a little bit. The power of compound interest will really grow your nest egg, and your future self will be very grateful. That you did. So now a question comes up like, well, what about Social Security? Well, it is true that Social Security benefits are partly based on the amount of either like payroll taxes or self-employment tax that you pay. And if you convert from sole proprietor to S corp, you are now paying a lot less in you know, um, Social Security contributions. All right, so is it worth taking the money you would have paid to Social Security and kind of self-directing it, putting it in your own retirement accounts? Well, for illustration, uh, let's take a person who works for 35 years and they retire at the full retirement age, which is 67 years old. By the way, you can withdraw from your IRAs at 59 and a half. You don't have to wait till 67. Well, if you did that and you earned $50,000 a year, your benefits would be about $1,613 a month. If you earned $150,000 a year and paid all that extra FICA, that $15,000 a year FICA, your earnings from Social Security would be $3,147 a month. So it is true that, you know, by electing S corp, you are going to receive about $18,408 less in Social Security benefits than the person who put their money into their retirement account. But the person with the retirement account is going to have that $2.4 million nest egg. So how long would you have to live and collect Social Security before the extra benefits outweighed having the nest egg? Well, it's about 200 years. After about 200 years, if you could live that long, then Social Security would, would earn you more than that nest egg. Um, actually, you would never catch up to your nest egg because it would continue to grow, but you know, apples to apples, especially if you're doing the 4% rule. Exactly. Now, now you're your own Social Security Administration.

Yeah, right.

You're not worried about Congress spending that money on something else or making cuts or raising the retirement age. You're, you're taking control of your own future. So not discouraging. S corp and retirement savings, just trying to be transparent and letting you know, yes, you will receive less Social Security, but the money in your retirement account will be way, way more valuable.

Yeah. And we also don't know exactly what's going to happen with Social Security. It's been bankrupt for a little while. And like you said earlier, are they going to have to make some sort of change? and it's probably not going to be a good change. Like, oh, we're going to get more money now. It's somehow they're, they're probably going to have to lower the, uh, what they're paying out on Social Security. I mean, I don't know, but you know, that is a, that is a risk, you know, that's, that you run by relying on the, the government to, to give you money after retirement.

Yeah. I mean, our generation is having fewer and fewer children. No, Social Security is always dependent on the current generation paying taxes to fund the retirement benefits of the previous generation. And if we are having fewer children, that's fewer dollars to fund our Social Security benefits. Uh, I don't want to—

I've done my part. I've had 3 kids, so I don't know.

And we salute you. No, Daniel has done his part. I am behind. I have one child. I love him to death, but I am not contributing to future Social Security payments as much as I should be.

Yeah. So I just have to make sure that he's extra productive.

Yes. And he does no tax planning.

Right.

He pays as much taxes as possible. So that's not going to happen. I'm not going to allow that. So, so, but yeah, it's, it's, I mean, it is up to you. Some people like the perceived security of Social Security, especially if you're a little bit older. You may need, you may not have time to build your nest egg if you're in your late 50s. And so maybe it makes sense to pay more in Social Security tax to get, to get those benefits. But for the most of us, I'm going to say put your trust in yourself to manage your own money instead of allowing Congress to do it. You will probably come out better just on average. So I love this tax strategy. I know this, this podcast has run a little bit long, but the reason I love this tax strategy is it doesn't require you to spend any extra money. This is money you're already spending. We're just deploying it in a strategic, tax-advantaged way. It gives you control of your financial future. You're not dependent on the government to provide your retirement. You're taking control of your own destiny. It does require good planning, and it also requires understanding on how to put the tax and legal system to work for for you. There's obviously more to it than we were able to cover, and there's other strategies that can build your nest egg even more. Um, so you want to have some, some good advocates in your court, people who can help you navigate this and show you the best way to do it. Uh, this is just really one of many strategies that will help you to build wealth provide for your future generations and to give generously. A lot of people would kind of call that the American dream. I think it's definitely worth pursuing and giving you the power and ability to decide how you want your life to go. I find that to be, you know, very satisfying.

Awesome. We'd love to hear your thoughts on this tax strategy if you have, maybe you've tried to do something like this already, like to hear what you've done, or if you have any questions about this, we'd love to hear you, hear from you. If you go to Facebook and type in Grow Your Painting Business, you can find the private Facebook group. Just request access and we'll let you in and love to hear from you.

Yeah, absolutely. Drop us your comments, your questions. We'll do our best to answer. And definitely good luck to everyone who is working hard to build their nest egg. You can do it, and you can certainly find people to help you along the way and point you in the right direction. So thank you very much for listening, and we will see you on the next episode.